|By Lucia Mutikani

WASHINGTON (Reuters) - U.S. consumer prices rose more than expected in August as healthcare costs recorded their biggest gain in 32-1/2 years, pointing to a steady build-up of inflation that could allow the Federal Reserve to raise interest rates this year.

The cost of living last month was also pushed up by sustained increases in rents. The uptick in inflation is likely to be welcomed by Fed officials when they gather next week to deliberate on monetary policy, though a rate hike is not expected at that meeting.

"The economy may not be firing on all cylinders, but growth is enough to spark a little more inflation than we thought. The Fed decision is going down to the wire," said Chris Rupkey," chief economist at MUFG Union Bank in New York.

The Labor Department said on Friday its Consumer Price Index increased 0.2 percent last month after being unchanged in July. In the 12 months through August, the CPI increased 1.1 percent after advancing 0.8 percent in the year through July.

The so-called core CPI, which strips out food and energy costs, rose 0.3 percent last month, the biggest increase since February, after gaining 0.1 percent in July.

Economists had forecast the CPI nudging up 0.1 percent last month and the core CPI gaining 0.2 percent. The core CPI increased 2.3 percent in the 12 months through August after rising 2.2 percent in the year through July.

The dollar rallied against a basket of currencies on the data, while prices for U.S. Treasuries were mixed. U.S. stocks were trading lower, with sentiment also hurt by declining oil prices and the U.S. Justice Department's demand for $14 billion from Deutsche Bank to settle claims related to sales of mortgage-backed securities.

The Fed is expected to leave interest rates unchanged next week against the backdrop of a raft of disappointing economic reports for August, including weak retail sales and industrial production as well as a slowdown in job growth.

A separate report on Friday, however, showed consumer sentiment was steady in early September, suggesting retail sales could rebound in the coming months.

The U.S. central bank has a 2 percent inflation target and tracks an inflation measure that has been stuck at 1.6 percent since March. Fed Governor Lael Brainard said on Monday she wanted to see stronger consumer spending data and signs of rising inflation before hiking rates.

'DARK CLOUD'

The Fed raised its benchmark overnight interest rate at the end of last year for the first time in nearly a decade, but has held it steady this year amid concerns over persistently low inflation. Many economists expect the Fed to increase borrowing costs at its December policy meeting.

Medical care costs jumped 1.0 percent last month, the largest increase since February 1984, after advancing 0.5 percent in July. The cost of hospital services jumped 1.7 percent, the biggest gain since October 2015. Prices for prescription medicine soared 1.3 percent.

Economists linked the surges to the expansion of healthcare coverage under President Barack Obama's signature 2010 healthcare restructuring law.

"This, of course, is the dark cloud surrounding the good-news story about record numbers of people signing up for health insurance," said Jay Morelock, an economist at FTN Financial in New York. "The bulk of the increase was among the population with pre-existing conditions, which has significantly boosted costs for all."

Given the strong increases in healthcare costs, economists are forecasting the Fed's preferred measure - the core personal consumption expenditures (PCE) price index - to rise 0.2 percent in August after increasing 0.1 percent in both June and July.

That would take the year-on-year gain to 1.7 percent, which would be the biggest increase since February. The CPI and PCE price index diverge in part due to differences in coverage and weights assigned to healthcare and housing costs.

"With the economy near full employment and more and more signs of higher wage and unit labor cost inflation, the risks are rising that it will be PCE moving up to CPI," said Torsten Slok, chief international economist at Deutsche Bank Securities in New York. "In that case, the Fed will no longer have the luxury of being slow, gradual and cautious."

Last month, owners' equivalent rent of primary residence rose 0.3 percent in August. It has risen by the same margin every month since April. Americans also paid more for motor vehicle insurance and apparel. Prices for tobacco also rose.

But households got some relief from gasoline prices, which fell 0.9 percent last month. Food prices were unchanged, with the cost of food consumed at home declining for a fourth straight month.